The future of Ukraine – and the role of sound money

The recent protests leading to the replacement of the government of Victor Yanukovych, reflected a widely held desire for the rule of law and normal individual freedoms and dignity. The few thousands who demonstrated in the Maidan (Independence Square) starting November 21, 2013 following the surprise refusal of then President Yanukovych to sign Association and Free Trade Agreements with the EU, swelled to almost one million by December 1 in response to police attacks on the demonstrating students.

The Ukrainian public, countrywide, is outraged at the corruption of its government and wants a new direction more reflective of western values. President Yanukovych was removed from office on February 22 by a vote of 328 of 447 members of the Ukrainian parliament. Ukraine’s leadership has changed a number of times since the collapse of the Soviet Union without any significant change in governance and corruption. More than the head of state needs to change. Having been disappointed before, the barricades and tents of the Maidan demonstrators remain in place, and their occupants vow to stay to monitor the new government at least until the Presidential elections scheduled for May 25.

The foundation of a just and prosperous society includes clear and secure property rights, limited government, free markets, honest and efficient courts, and sound money. All of these “institutions of capitalism” are important. Greatly reducing if not eliminating corruption is important in the same way that a healthy body is more productive than a sick, parasite infected one. Fortunately many of the measures that Ukraine needs to take in order to be economically more efficient and productive also reduce many of the sources of public corruption. Most government interferences with private markets such as fixing prices, imposing foreign currency exchange controls, granting special business or tax preferences, etc., create opportunities and incentives for corruption. Eliminating them is thus win-win.

Sound money is important for economic growth and for fair and equal treatment of citizens under the law. It enables businesses and investors to better evaluate the most profitable investments for the future by removing the distorting noise of inflation. Inflation is rarely a smooth process thus distorting relative prices and the allocation of resources that are determined by them. The better a country’s resources are allocated the faster it will grow. Sound money also saves individuals and household the time and energy needed to minimize the cost to them of holding and using an inflating currency. These costs fall disproportionately on the poor. Inflations tend to redistribute wealth from the poor to the rich and from the general public to government via the profits of its inflating central bank.

The strong correlation between sound money and economic wellbeing is shown in the first chart below. Countries with the lowest inflation rates have the highest per capital incomes. There is also a strong correlation between measures of economic freedom and economic efficiency (minimal government interference with the economy), which includes low inflation, and the rate of economic growth and the level of per capital income. These are revealed in the second and third charts below.

See Figure 1 & Figure 2  

Figure 1 above: Inflation and Per Capita Income

Figure 2  


Other than using another countries currency (dollarization), any monetary policy regime will struggle to achieve sound money under the pressures of a bloated and inefficient government and its financing needs. As the Ukrainian government has confronted higher risk premiums when attempting to borrow in the external debt market, it has turned increasingly to the National Bank of Ukraine (NBU) for financing. 162 billion hryvnias of Ukraine’s 588 billion public sector debt (which included the large debt of Naftogaz) was financed by the NBU at the end of 2013.

Most of the external financial assistance being prospectively offered to Ukraine merely replaces existing external debt with lower cost official debt (i.e. rolls over existing maturing debt to the external private sector with new debt to foreign governments and international financial institutions) and spreads out the rate at which the government must cut subsidies and other wasteful and distorting expenditures. Every special interest group hit by these cuts will fight to preserve the status quo. A successful monetary policy, one that preserves the stable value of its currency, will be difficult in this environment. Reducing the size and reach of Ukraine’s government and the many regulatory distortions introduced by it is of critical importance, but is a topic beyond the scope of this note, which addresses how best to establish sound money.

See Figure 3 


The single most important prerequisite for sound money is strong public support for it. The public needs to understand and support the value of stable money for economic efficiency, growth and fairness. Unexpected inflation redistributes income from savers/creditors to borrowers/debtors. The burden of inflation falls heaviest on the poor who are least able to avoid the so-called inflation tax (the reduction in the value of the money they hold). Many Ukrainians will remember the near hyperinflation of 1992-3 and thus are likely to understand its hardships. The German population is famously strongly anti inflation following Germany’s experience with hyperinflation in the 1920s.

This strong aversion to inflation by Germans has assured the stability of the German Mark until it was replaced by an equally stable Euro. Public support for sound money will translate into political support.

The second most important prerequisite is the independence (and accountability) of the central bank to use its policy instruments to maintain price stability. The National Bank of Ukraine has such independence in the Law on the National Bank of Ukraine, but it will enjoy it in fact only as long as public and political opinion supports its efforts to preserve price stability. The performance of the NBK in the past has been mixed.

For the past year the NBK has supported an overvalued exchange rate with its rapidly declining foreign exchange reserves combined with a tight monetary policy (high interest rates) in an effort to reduce the demand for foreign exchange. The IMF in its most recent Article IV consultation with Ukraine summarized the situation as follows:

“An overvalued exchange rate, large fiscal deficit, and sizable quasi-fiscal losses keep the current account deficit well above equilibrium. Under unchanged policies, the NBU’s international reserves and other buffers will be further depleted during 2014, making the country particularly vulnerable to disruptive shocks. Rising risk perception reflected in sovereign rating downgrades by all major rating agencies makes it much more difficult for the sovereign and corporates to raise external market financing, while domestic sources of financing are limited. Tight monetary policy in support of the exchange rate constrains private investment, while public investment is being displaced by high wage and pension spending. Together with the difficult business climate, these factors keep growth depressed.” IMF December 2013.

Clearly these policies were not sustainable and the NBU has already allowed the exchange rate to depreciate substantially. An important policy question for the new government is what monetary policy regime will be most resistant to the pressures of fiscal dominance (while at the same time taking steps to eliminate it), and enjoy the greatest support of the public, and thus be the most likely to deliver stable money. Ukraine should choose between currency board rules (fixed to a small basket of currencies, e.g., USD, euro and RUB) and inflation targeting. The first requires a legally fixed exchange rate (most likely to the euro or the SDR) and the second a freely floating, market determined exchange rate with a legally mandated commitment to an inflation target. Inbetween regimes of managed exchange rates have not and are not likely to work in Ukraine.

The currency board option has advantages and disadvantages. It is the simplest of all monetary policy regimes to administer (there is no monetary policy per se and the supply of money is determined by the public in light of its demand and the fixed exchange rate) and for the public to understand (the exchange rate is visible on a daily basis). While the central bank supplies (sells) banknotes on demand to banks and the public, it cannot lend to banks and thus cannot provide lender of last resort support to banks. This forces banks to manage their liquidity carefully and to make their own liquidity support arrangements (generally with other banks domestic and/or foreign), which can strengthen the resilience of the banking sector.

Moreover, the greater transparency and exchange rate certainty of currency board rules greatly diminish the likelihood of depositors periodically rushing to convert their deposits to cash at all banks at once thus reducing the risk of liquidity crises. More importantly, under currency board rules the central bank cannot lend to the government (or anyone else) and is thus the monetary policy regime most resistant to the pressures of fiscal dominance. If the government is to honor the legal requirements of currency board rules, it will be forced to reduce its expenditures and deficits to levels it can comfortably finance in the market.

A disadvantage of currency board rules is that real exchange rate adjustments, which are likely to be significant as Ukraine undertakes many structural reforms, will require and force modest inflation and/or deflation. With flexible exchange rates, these adjustments could be made (in principle at least) by nominal exchange rate appreciations or depreciations with stable domestic prices.

The success of a currency board arrangement rests heavily on the credibility of its commitment to the rules (issuing and redeeming its currency in response to public demand at the fixed exchange rate). This credibility rests in part on the adequacy of its foreign currency reserves. A currency board must be 100 percent marginally backed by its anchor currency (or basket), i.e., it must sell its currency and be willing to redeem it for the anchor at the legally fixed exchange rate. Ideally, its monetary liabilities (base money) should be 100 percent backed by the anchor, but this is not really essential. The NBU’s FX reserves (currency backing), however, are very low by any standard.

Gross reserves of US$18.5 billion at end of 2013 were only 2.2 months of imports of goods and services and 32 percent of short-term external debt. Of particular relevance to the credibility of currency board rules, the NBU’s Net International Reserves were barely above one third of its monetary liabilities (base money) even at exchange rates after the sharp depreciation on February 28 (following the more gradual depreciation starting the first of this year). Experience with other countries is that donors are not willing to lend, much less give (as is really required) their currencies to be held as reserves of the central bank (for currency backing purposes). However, donor money, including new IMF money, will go largely to cover existing external debt repayments.

If Ukraine were to adopt currency board rules, it would need to fix the exchange rate to the anchor currency at a sufficiently depreciated rate to remove any pressure on the NBUs low level of foreign exchange reserve cover. The depreciation this year (from around 8 UAH per USD between 2011-13 to 10 UAH per USD on February 28, 2014) basically eliminated the overvaluation estimated by the IMF. Given the initial low level of the NBU’s foreign exchange reserves it would be wise to err a bit on the side of over depreciation. If the rate is over depreciated, people will buy hryvnias with the anchor currency, thus increasing the NBU’s reserves and causing a mild inflation until balance is achieved.

The inability of the central bank to lend to banks under currency board rules requires that banks be relatively well capitalized and sound. Ukraine’s banks have strengthened following the financial crisis of 2008 and are now thought to be relatively well capitalized, though non-performing loans remain too high. As banks generally have a negative foreign currency exposure (FX liabilities greater than FX assets) as a result of regulatory restrictions on foreign assets (presumably part of the exchange controls imposed to help conserve foreign currency reserves), they will have suffered losses from the hryvnias’ recent devaluation.

Moreover, as some of banks’ foreign currency assets are actually loans to local businesses and households denominated in foreign currency, these loans will be harder to repay following the devaluation to the extent that borrowers do not have foreign currency income. As a result, banks may experience increases in non-performing loans in the coming months. Ukraine has relatively efficient legal bank resolution provisions, but limited experience in using them. Such tools are particularly critical for countries following currency board rules, as such central banks are not able to lend to failing banks. The failures of systemically important banks are normally resolved gradually with interim financing from the government/central bank.

This would not be possible under currency board rules. The recent resolutions of two large banks in Cyprus without the use of public (or central bank) funds by bailing in (i.e. putting the losses on) bank creditors, provides the model needed.

The other option for the NBU and the one it has been preparing for is to freely float its exchange rate and anchor policy with an inflation target. This is the most flexible policy regime and the most challenging to implement. As with any policy regime, the success of inflation targeting depends heavily on the credibility of the central bank’s commitment to the target and its capacity to achieve it on average over time.

The price level is never perfectly constant under any policy regime and would not be under inflation targeting (or a currency board). But if the public believes that the NBU is committed to its inflation target on average over time and has the expertise to achieve it on average over time, it will expect the rate of inflation to be the targeted rate and will formulate its decisions (e.g. wage demands) on that basis. When the public expects the targeted rate of inflation, its behavior that incorporates that expectation helps the central bank achieve its target with minimal impact on real economic activity.

Needless to say, central banks gain credibility only via a successful track record. Two very successful inflation targeting central banks, the Czech National Bank and the National Bank of Poland, took a number of years to gain such credibility. Until the NBU was able to achieve such credibility, its policy actions to offset potential inflationary forces, even if it is able to resist fiscal pressures to finance the government, would have more negative impact on economic activity than otherwise. Unfortunately, the NBU’s actual behavior in recent years has increasingly sought to repress foreign exchange market pressures to depreciate, i.e. exchange controls of one sort or the other, in order to preserve low and declining foreign exchange reserves.

Ukraine’s best choice of monetary policy regimes is not obvious and will depend heavily on the judgment of knowledgeable Ukrainians of which approach is most likely to weather the economic and political storms ahead. It is promising that Ukraine’s interim President, Alexander Turchinov, has publicly pledged his support to implementing the budget saving reforms recommended by the IMF. Success in maintaining sound money will depend on it.

While currency board rules carry the risks discussed above (low foreign currency backing and no lender of last resort capability), they have several formidable advantages. In addition to simplicity and transparency, which potentially give the policy almost instant credibility, by removing any active central bank role they significantly reduce areas of potential rent seeking (i.e., corruption) associated with central bank lending and foreign exchange market intervention.

Given all of the uncertainties that seem unavoidable over the next few years, the greater certainty and simplicity of currency board rules have a lot to recommend them.



Figure 1: Inflation and Per Capita Income